1
Chapter 6 – Political Economy
Public Economics
2
Political Economy Defined
? Political Economy is the application of economic
principles to the analysis of political decision
making,
– Self-interest – in the marketplace,this often leads to
efficiency; different implications in,political market.”
– Maximization – one goal may be to maximize social
welfare.
3
Direct Democracy
? Several kinds of voting procedures:
– Unanimity rules
– Majority voting rules
– Logrolling
? Problems with all of these rules,Arrow’s
Impossibility Theorem
4
Direct Democracy:
Unanimity rules
? Unanimity rules,All parties must agree
for a policy to be implemented.
– Example,In principle,society could agree
that a public good should be provided rather
than not being provided.
? Lindahl prices designed to elicit
unanimous agreement for provision of
public good.
5
Direct Democracy:
Example of Lindahl’s procedure
? 2 individuals,Adam & Eve
? Fireworks display (public good,denote as r)
? SA =Adam’s share of total cost of fireworks
provision
? For any given share,SA,Adam demands some
quantity of fireworks.
Figure 6.1
7
Direct Democracy:
Example of Lindahl’s procedure
? Figure 6.1 shows the relationship between each person’s
tax share & quantity of fireworks demanded.
? Each person demands more fireworks as the share of costs
paid falls.
? Shares add up to one,SA+SE=1
? Lindahl prices,Each person faces a,personalized price”
per unit of the public good,which depends on the tax share.
8
Direct Democracy:
Example of Lindahl’s procedure
? Equilibrium,set of Lindahl prices such
that each person votes for the same
quantity of the public good.
? In Figure 6.1,this occurs at quantity r*,
and each person’s share is measured on
the x-axis.
9
Direct Democracy:
Feasibility of Lindahl’s procedure
? Could imagine an auctioneer announces
initial set of tax schedules,then Adam &
Eve vote on quantity of fireworks.
– If they agree on quantity,stop,Otherwise,
continue process with new tax shares.
? Would converge to r*,which is Pareto
efficient.
10
Direct Democracy:
Feasibility of Lindahl’s procedure
? Problems:
? Assumes people vote sincerely
– Strategic behavior (e.g.,misrepresenting
one’s preferences) may prevent Lindahl
equilibrium
? Finding tax shares may take a lot of time.
– Imagine many parties,not just two.
11
Direct Democracy:
Majority Voting rules
? Majority Voting rules,one more than
half of the votes must favor a measure to
gain approval.
? Although the rules are familiar,potential
problems with them.
12
Direct Democracy:
Majority Voting rule example
? 3 people have to choose among 3 levels of
missile provision
– A is small amount of provision
– B is moderate amount of provision
– C is large amount of provision
? People are Cosmo,Elaine,and George
? Preferences are shown in Table 6.1
Table 6.1
14
Direct Democracy:
Majority Voting rule example
? In Table 6.1,the quantity B would win in an
election of B vs,A (by a vote of 2-1,with Elaine
and George voting for B).
? B would also win in an election of B vs,C (by a
vote of 2-1,with Cosmo and George voting for
B).
? Selection of B in this case is independent of the
order in which the votes are taken.
15
Direct Democracy:
Majority Voting rule example
? Now consider the preferences are shown
in Table 6.2
Table 6.2
17
Direct Democracy:
Majority Voting rule example
? In Table 6.2,imagine a series of paired
elections to determine the most preferred level,
Elaine’s preferences are the only ones that
have changed.
– The quantity A would win in an election of A vs,B (by
a vote of 2-1,with Cosmo and Elaine voting for A).
– The quantity B would win in an election of B vs,C (by
a vote of 2-1,with Cosmo and George voting for B).
– The quantity C would win in an election of A vs,C (by
a vote of 2-1,with Elaine and George voting for B).
18
Direct Democracy:
Majority Voting rule example
? Thus,the ultimate outcome depends crucially
on the order in which the votes are taken.
? It is clear in this example that whichever
quantity was not considered in the first round
would ultimately win.
? Agenda manipulation is the process of
organizing the order of votes to assure a
favorable outcome.
19
Direct Democracy:
Majority Voting rule example
? Another problem is cycling,paired voting
can go on forever without reaching a
decision.
20
Direct Democracy:
Why difficulties with Majority
Voting rule?
? A peak in an individual’s preferences are a
point at which all neighboring points are lower.
– Single peaked preferences,utility falls as person
moves away from most preferred outcome in any &
all directions.
– Double peaked preferences,utility initially falls as
person moves away from most preferred outcome,
but then rises.
21
Direct Democracy:
Why difficulties with Majority
Voting rule?
? In Figure 6.2,Elaine has double-peaked
preferences as quantity increases.
? This means she prefers either very large
or very small missile expenditures to a
quantity in the middle.
Figure 6.2
23
Direct Democracy:
Why difficulties with Majority
Voting rule?
? How plausible are double-peaked preferences?
– It depends on the context.
– Missiles,not very plausible
– Public park,more plausible,good for which there are
private substitutes.
– Goods which cannot be ordered on a single
dimension like,size.” The use of a vacant building,
for example.
24
Direct Democracy:
Majority Voting rules
? Return to case when alternatives can be ranked
on a characteristic,like size or quantity.
? The median voter is the voter whose
preferences lie in the middle of the set of all
voter’s preferences.
– Half of voters want more of the good,and half want
less.
25
Direct Democracy:
Median voter theorem
? The median voter theorem states that
as long as all preferences are single-
peaked,the outcome of majority voting
reflects the preferences of the median
voter.
26
Direct Democracy:
Median voter theorem illustrated
? Consider the 5 voters in Table 6.3,each
with single-peaked preferences.
? Each voter’s individually preferred
expenditure is given in the table.
Table 6.3
28
Direct Democracy:
Median voter theorem illustrated
? A movement from $0 to $5 would be by all five voters.
? A movement from $0 to $100 would be approved by Daisy,
Huey,Dewey,and Louie.
? A movement from $100 to $150 would be approved by
Huey,Dewey,and Louie.
? Any increase above $150 would be blocked by a majority of
voters,Hence the majority votes for $150,which is the
preferred amount of the median voter,Huey.
29
Direct Democracy:
Logrolling
? Logrolling systems allow people to trade
votes,and hence register how strongly
they feel about various issues.
– Vote trading is controversial,but may lead to
more efficient provision of public goods.
30
Direct Democracy:
Logrolling Example
? Consider the benefits from 3 different
projects for 3 people.
? Negative values mean a net loss.
Table 6.4
32
Direct Democracy:
Logrolling Example
? Table 6.4 shows the net benefit for each
project is positive,but under a simple
majority rule scheme,none get approved.
– Net benefit is negative for two of the voters
in each case (but small),and positive for one.
? By trading votes,possible to get all 3
approved,and society gains welfare.
33
Direct Democracy:
Logrolling Example
? Logrolling could lead to inefficient
outcomes,however.
? Vary the benefits for all 3 projects,so that
the net benefit of each is now negative in
Table 6.5.
? Here vote trading can lead to inefficient
passage.
Table 6.5
35
Direct Democracy:
Logrolling Example
? In the second example,a majority of
votes form a coalition to vote for projects
that serve their interests,but whose costs
are borne mainly by the minority of voters.
36
Direct Democracy,Problems
? Can any ethically acceptable method for
translating individual preferences into
collective preferences be free of
difficulties discussed so far?
37
Direct Democracy,Problems
? Criteria for decision making rule
– 1,Rule can produce a decision whatever
the configuration of voters preferences (e.g.,
double-peaked,etc.)
– 2,Rule can rank all possible outcomes
– 3,Rule must be responsive to individual
preferences.
38
Direct Democracy,Problems
? Criteria for decision making rule
– 4,Rule must be consistent (e.g.,transitivity)
– 5,Rule must be able to rank two policies
independent of irrelevant alternatives.
– 6,No dictatorship,Social preferences must
not reflect preferences of only one individual.
39
Direct Democracy,Problems
? Arrow’s Impossibility Theorem states
that it is impossible to find a decision rule
that satisfies all of these criteria.
? These 6 criteria,taken together,seem
reasonable.
? But theorem casts doubt on the ability of
democracies to function.
40
Direct Democracy,Problems
? If any one of the 6 criteria are dropped,it is
possible to find a collective decision making
rule.
? It is sometimes possible,but not guaranteed,to
find a decision making rule.
– E.g.,if everyone has same preferences.
? Theorem casts doubt on the use of social
welfare functions.
41
Representative Democracy
? In reality,government doesn’t simply
aggregate people’s preferences; rather
the governing is done by politicians,
judges,bureaucrats,and so on.
? These players have their own objective
functions.
42
Representative Democracy:
Politicians
? Elected Politicians,If voters have single
peaked preferences,the vote-maximizing
politician adopts the preferred program of
the median voter.
? See Figure 6.3.
– Candidates move to middle of spectrum,
because voters support candidate with view
closest to own,and only one wins.
Figure 6.3
44
Representative Democracy:
Politicians
? Implications:
– 2 party systems tend to be,stable” in the
sense that both stake out positions near the
“center.”
– Replacement of direct referenda (e.g.,direct
democracy) by a representative system has
no effect on outcome,Both mirror the
preferences of median voter.
45
Representative Democracy:
Politicians
? Real-life complications
– Ideology matters,politicians care about more than
just winning elections.
– Personality,voters care about more than just issues.
– Leadership,politicians do not simply respond to
voter’s preferences.
– Voter participation,may be affected by relative
difference in candidates
46
Representative Democracy:
Public employees/bureaucrats
? Bureaucrats,government employees.
? Na?ve to assume that a bureaucrat's only aim is
to interpret and passively fulfill the wishes of the
electorate and its representatives.
? Niskanen (1971) argues that bureaucrats tend
to focus on maximizing perquisites of public
office,public reputation,power,etc.,because
opportunities for monetary gains are minimal.
Figure 6.4
48
Representative Democracy:
Public employees/bureaucrats
? In previous figure,bureaucrat doesn't
choose the efficient amount for the
project,Q*,where MB=MC,but rather
chooses a larger project,Qbc,where
TB=TC.
? Project doesn’t suffer losses,but is
inefficient.
49
Representative Democracy:
Public employees/bureaucrats
? Bureaucrats have incentive to promote
activities that increase the sponsor’s
perceptions of the project’s benefits.
– Analogous to shifting the V curve upward.
? Bureaucrats have informational
advantage,to present the alternatives as
“take Qbc or none at all.”
50
Representative Democracy:
Special Interests
? Special interest groups can form
coalitions and exercise a disproportionate
amount of power if they vote in blocks or
make campaign contributions.
? Groups form based on many factors,
including capital vs,labor,rich vs,poor,
industries,regions,and demographics.
51
Representative Democracy:
Special Interests
? Rent-seeking is using the government to
obtain higher than normal returns
(“rents”).
? One example,illustrated in Figure 6.5,is
the peanut industry lobbying the
government to impose peanut quotas,
This enforces a cartel-like arrangement.
Figure 6.5
53
Representative Democracy:
Special Interests
? In Figure 6.5,the competitive output would be
at Qc.
? The peanut industry could try to form an illegal
cartel to restrict output to Qcartel,but each firm
has an individual incentive to cheat.
? If producers can lobby for quotas,they can
enforce this output level.
54
Representative Democracy:
Special Interests
? Standard deadweight loss from reduced
output is equal to triangle cde.
? To the extent that the economic rents,
abcd,are spent on socially wasteful
lobbying (rather than being a transfer to
producers),this is also considered
deadweight loss.
55
Explaining Government Growth
? Various reasons to explain growth in
government expenditure
– Citizen preferences
– Marxist view
– Chance events
– Changes in social attitudes
– Income redistribution
56
Controlling Government Growth
? Private sector competition
? Reforming budget process
? Constitutional amendments
57
Recap of Political Economy
? Political Economy definition
? Direct Democracy
? Representative Democracy
? Government Growth
Chapter 6 – Political Economy
Public Economics
2
Political Economy Defined
? Political Economy is the application of economic
principles to the analysis of political decision
making,
– Self-interest – in the marketplace,this often leads to
efficiency; different implications in,political market.”
– Maximization – one goal may be to maximize social
welfare.
3
Direct Democracy
? Several kinds of voting procedures:
– Unanimity rules
– Majority voting rules
– Logrolling
? Problems with all of these rules,Arrow’s
Impossibility Theorem
4
Direct Democracy:
Unanimity rules
? Unanimity rules,All parties must agree
for a policy to be implemented.
– Example,In principle,society could agree
that a public good should be provided rather
than not being provided.
? Lindahl prices designed to elicit
unanimous agreement for provision of
public good.
5
Direct Democracy:
Example of Lindahl’s procedure
? 2 individuals,Adam & Eve
? Fireworks display (public good,denote as r)
? SA =Adam’s share of total cost of fireworks
provision
? For any given share,SA,Adam demands some
quantity of fireworks.
Figure 6.1
7
Direct Democracy:
Example of Lindahl’s procedure
? Figure 6.1 shows the relationship between each person’s
tax share & quantity of fireworks demanded.
? Each person demands more fireworks as the share of costs
paid falls.
? Shares add up to one,SA+SE=1
? Lindahl prices,Each person faces a,personalized price”
per unit of the public good,which depends on the tax share.
8
Direct Democracy:
Example of Lindahl’s procedure
? Equilibrium,set of Lindahl prices such
that each person votes for the same
quantity of the public good.
? In Figure 6.1,this occurs at quantity r*,
and each person’s share is measured on
the x-axis.
9
Direct Democracy:
Feasibility of Lindahl’s procedure
? Could imagine an auctioneer announces
initial set of tax schedules,then Adam &
Eve vote on quantity of fireworks.
– If they agree on quantity,stop,Otherwise,
continue process with new tax shares.
? Would converge to r*,which is Pareto
efficient.
10
Direct Democracy:
Feasibility of Lindahl’s procedure
? Problems:
? Assumes people vote sincerely
– Strategic behavior (e.g.,misrepresenting
one’s preferences) may prevent Lindahl
equilibrium
? Finding tax shares may take a lot of time.
– Imagine many parties,not just two.
11
Direct Democracy:
Majority Voting rules
? Majority Voting rules,one more than
half of the votes must favor a measure to
gain approval.
? Although the rules are familiar,potential
problems with them.
12
Direct Democracy:
Majority Voting rule example
? 3 people have to choose among 3 levels of
missile provision
– A is small amount of provision
– B is moderate amount of provision
– C is large amount of provision
? People are Cosmo,Elaine,and George
? Preferences are shown in Table 6.1
Table 6.1
14
Direct Democracy:
Majority Voting rule example
? In Table 6.1,the quantity B would win in an
election of B vs,A (by a vote of 2-1,with Elaine
and George voting for B).
? B would also win in an election of B vs,C (by a
vote of 2-1,with Cosmo and George voting for
B).
? Selection of B in this case is independent of the
order in which the votes are taken.
15
Direct Democracy:
Majority Voting rule example
? Now consider the preferences are shown
in Table 6.2
Table 6.2
17
Direct Democracy:
Majority Voting rule example
? In Table 6.2,imagine a series of paired
elections to determine the most preferred level,
Elaine’s preferences are the only ones that
have changed.
– The quantity A would win in an election of A vs,B (by
a vote of 2-1,with Cosmo and Elaine voting for A).
– The quantity B would win in an election of B vs,C (by
a vote of 2-1,with Cosmo and George voting for B).
– The quantity C would win in an election of A vs,C (by
a vote of 2-1,with Elaine and George voting for B).
18
Direct Democracy:
Majority Voting rule example
? Thus,the ultimate outcome depends crucially
on the order in which the votes are taken.
? It is clear in this example that whichever
quantity was not considered in the first round
would ultimately win.
? Agenda manipulation is the process of
organizing the order of votes to assure a
favorable outcome.
19
Direct Democracy:
Majority Voting rule example
? Another problem is cycling,paired voting
can go on forever without reaching a
decision.
20
Direct Democracy:
Why difficulties with Majority
Voting rule?
? A peak in an individual’s preferences are a
point at which all neighboring points are lower.
– Single peaked preferences,utility falls as person
moves away from most preferred outcome in any &
all directions.
– Double peaked preferences,utility initially falls as
person moves away from most preferred outcome,
but then rises.
21
Direct Democracy:
Why difficulties with Majority
Voting rule?
? In Figure 6.2,Elaine has double-peaked
preferences as quantity increases.
? This means she prefers either very large
or very small missile expenditures to a
quantity in the middle.
Figure 6.2
23
Direct Democracy:
Why difficulties with Majority
Voting rule?
? How plausible are double-peaked preferences?
– It depends on the context.
– Missiles,not very plausible
– Public park,more plausible,good for which there are
private substitutes.
– Goods which cannot be ordered on a single
dimension like,size.” The use of a vacant building,
for example.
24
Direct Democracy:
Majority Voting rules
? Return to case when alternatives can be ranked
on a characteristic,like size or quantity.
? The median voter is the voter whose
preferences lie in the middle of the set of all
voter’s preferences.
– Half of voters want more of the good,and half want
less.
25
Direct Democracy:
Median voter theorem
? The median voter theorem states that
as long as all preferences are single-
peaked,the outcome of majority voting
reflects the preferences of the median
voter.
26
Direct Democracy:
Median voter theorem illustrated
? Consider the 5 voters in Table 6.3,each
with single-peaked preferences.
? Each voter’s individually preferred
expenditure is given in the table.
Table 6.3
28
Direct Democracy:
Median voter theorem illustrated
? A movement from $0 to $5 would be by all five voters.
? A movement from $0 to $100 would be approved by Daisy,
Huey,Dewey,and Louie.
? A movement from $100 to $150 would be approved by
Huey,Dewey,and Louie.
? Any increase above $150 would be blocked by a majority of
voters,Hence the majority votes for $150,which is the
preferred amount of the median voter,Huey.
29
Direct Democracy:
Logrolling
? Logrolling systems allow people to trade
votes,and hence register how strongly
they feel about various issues.
– Vote trading is controversial,but may lead to
more efficient provision of public goods.
30
Direct Democracy:
Logrolling Example
? Consider the benefits from 3 different
projects for 3 people.
? Negative values mean a net loss.
Table 6.4
32
Direct Democracy:
Logrolling Example
? Table 6.4 shows the net benefit for each
project is positive,but under a simple
majority rule scheme,none get approved.
– Net benefit is negative for two of the voters
in each case (but small),and positive for one.
? By trading votes,possible to get all 3
approved,and society gains welfare.
33
Direct Democracy:
Logrolling Example
? Logrolling could lead to inefficient
outcomes,however.
? Vary the benefits for all 3 projects,so that
the net benefit of each is now negative in
Table 6.5.
? Here vote trading can lead to inefficient
passage.
Table 6.5
35
Direct Democracy:
Logrolling Example
? In the second example,a majority of
votes form a coalition to vote for projects
that serve their interests,but whose costs
are borne mainly by the minority of voters.
36
Direct Democracy,Problems
? Can any ethically acceptable method for
translating individual preferences into
collective preferences be free of
difficulties discussed so far?
37
Direct Democracy,Problems
? Criteria for decision making rule
– 1,Rule can produce a decision whatever
the configuration of voters preferences (e.g.,
double-peaked,etc.)
– 2,Rule can rank all possible outcomes
– 3,Rule must be responsive to individual
preferences.
38
Direct Democracy,Problems
? Criteria for decision making rule
– 4,Rule must be consistent (e.g.,transitivity)
– 5,Rule must be able to rank two policies
independent of irrelevant alternatives.
– 6,No dictatorship,Social preferences must
not reflect preferences of only one individual.
39
Direct Democracy,Problems
? Arrow’s Impossibility Theorem states
that it is impossible to find a decision rule
that satisfies all of these criteria.
? These 6 criteria,taken together,seem
reasonable.
? But theorem casts doubt on the ability of
democracies to function.
40
Direct Democracy,Problems
? If any one of the 6 criteria are dropped,it is
possible to find a collective decision making
rule.
? It is sometimes possible,but not guaranteed,to
find a decision making rule.
– E.g.,if everyone has same preferences.
? Theorem casts doubt on the use of social
welfare functions.
41
Representative Democracy
? In reality,government doesn’t simply
aggregate people’s preferences; rather
the governing is done by politicians,
judges,bureaucrats,and so on.
? These players have their own objective
functions.
42
Representative Democracy:
Politicians
? Elected Politicians,If voters have single
peaked preferences,the vote-maximizing
politician adopts the preferred program of
the median voter.
? See Figure 6.3.
– Candidates move to middle of spectrum,
because voters support candidate with view
closest to own,and only one wins.
Figure 6.3
44
Representative Democracy:
Politicians
? Implications:
– 2 party systems tend to be,stable” in the
sense that both stake out positions near the
“center.”
– Replacement of direct referenda (e.g.,direct
democracy) by a representative system has
no effect on outcome,Both mirror the
preferences of median voter.
45
Representative Democracy:
Politicians
? Real-life complications
– Ideology matters,politicians care about more than
just winning elections.
– Personality,voters care about more than just issues.
– Leadership,politicians do not simply respond to
voter’s preferences.
– Voter participation,may be affected by relative
difference in candidates
46
Representative Democracy:
Public employees/bureaucrats
? Bureaucrats,government employees.
? Na?ve to assume that a bureaucrat's only aim is
to interpret and passively fulfill the wishes of the
electorate and its representatives.
? Niskanen (1971) argues that bureaucrats tend
to focus on maximizing perquisites of public
office,public reputation,power,etc.,because
opportunities for monetary gains are minimal.
Figure 6.4
48
Representative Democracy:
Public employees/bureaucrats
? In previous figure,bureaucrat doesn't
choose the efficient amount for the
project,Q*,where MB=MC,but rather
chooses a larger project,Qbc,where
TB=TC.
? Project doesn’t suffer losses,but is
inefficient.
49
Representative Democracy:
Public employees/bureaucrats
? Bureaucrats have incentive to promote
activities that increase the sponsor’s
perceptions of the project’s benefits.
– Analogous to shifting the V curve upward.
? Bureaucrats have informational
advantage,to present the alternatives as
“take Qbc or none at all.”
50
Representative Democracy:
Special Interests
? Special interest groups can form
coalitions and exercise a disproportionate
amount of power if they vote in blocks or
make campaign contributions.
? Groups form based on many factors,
including capital vs,labor,rich vs,poor,
industries,regions,and demographics.
51
Representative Democracy:
Special Interests
? Rent-seeking is using the government to
obtain higher than normal returns
(“rents”).
? One example,illustrated in Figure 6.5,is
the peanut industry lobbying the
government to impose peanut quotas,
This enforces a cartel-like arrangement.
Figure 6.5
53
Representative Democracy:
Special Interests
? In Figure 6.5,the competitive output would be
at Qc.
? The peanut industry could try to form an illegal
cartel to restrict output to Qcartel,but each firm
has an individual incentive to cheat.
? If producers can lobby for quotas,they can
enforce this output level.
54
Representative Democracy:
Special Interests
? Standard deadweight loss from reduced
output is equal to triangle cde.
? To the extent that the economic rents,
abcd,are spent on socially wasteful
lobbying (rather than being a transfer to
producers),this is also considered
deadweight loss.
55
Explaining Government Growth
? Various reasons to explain growth in
government expenditure
– Citizen preferences
– Marxist view
– Chance events
– Changes in social attitudes
– Income redistribution
56
Controlling Government Growth
? Private sector competition
? Reforming budget process
? Constitutional amendments
57
Recap of Political Economy
? Political Economy definition
? Direct Democracy
? Representative Democracy
? Government Growth
